It’s too early for the Fed to raise rates

FORTUNE — In her first press conference this week, incoming U.S. Federal Reserve Chair Janet Yellen indicated the central bank would reduce its bond purchases at a slightly quicker pace but also continued to de-emphasize the importance of the previously announced threshold of a 6.5% unemployment rate for raising short-term interest rates. Her remarks initially rattled markets, but this is actually a very sensible stance and one that shouldn’t have been news to anyone following the Fed’s announcements in recent months; the fact that markets hiccuped after hearing this indicates only that short-term stock movements convey essentially zero useful information.

Normally, economists would tell you that the Fed’s job is to manage a delicate trade-off between the two prongs of its dual mandate: keeping inflation low while maximizing employment. But since the beginning of 2008, a majority of macroeconomists has agreed that this normally delicate trade-off no longer exists, and that the Fed should focus on economic activity and employment, period. Unfortunately, that consensus shows signs of prematurely fraying. Some observers have started arguing that the time has come for the Fed to ease off the accelerator and start worrying about excessive inflation again — despite strong evidence that there is still a great deal of slack in the labor market.

That view is incorrect; we are not close to full employment, and the Fed should not take its foot off the accelerator until we get there.

It’s true that the unemployment rate has fallen rapidly in the last year — declining to 6.7% in February from 7.7 % a year ago. What’s more, short-term unemployment is nearly at pre-crisis levels. But while the Fed has previously indicated that they could raise rates once unemployment dips below 6.5%, this would be deeply premature. The economy has much more slack left in it than the headline unemployment number would indicate, and until this slack is nearly taken up, accelerating inflation won’t rear its head.

The simplest case against using the unemployment rate as our measure of slack is also the strongest: It has been driven down in recent years not by strong job growth but instead by potential workers dropping entirely out of the labor force due to weak job opportunities. Since the official count of unemployed workers only includes those actively searching for work, as jobless workers stop actively looking, the unemployment rate actually declines. A healthy economy will have to re-integrate these 5.7 million “missing workers” in coming years, and if some of these missing workers restart active job search in response to improving job prospects, the headline unemployment will actually see some stiff upward pressure.

A better measure of slack, which is not affected by such considerations, is simply the share of prime-age (25 to 54) adults with a job. This measure fell by 4.9 percentage points due to the Great Recession, and just over a third of that decline has been recouped. It is extraordinarily hard to imagine why such a significant share of prime-age workers would have stopped working in recent years, unless the economy had a large shortfall of demand relative to potential supply.

Other useful indicators of economic slack that Yellen has highlighted include measures of wage and price inflation. The core prices (excluding volatile food and energy costs) that are tracked closely by the Fed have fallen significantly below the Fed’s already too-conservative 2% long-run inflation goal. And unit labor costs — a key determinant of future inflation — actually shrank in the last quarter of 2013.

Finally, there are important reasons why the Fed should not raise rates even if inflation drifts over the Fed’s long-run target for a brief period. For one, these long-run inflation thresholds are too conservative over the short to medium term. Among other useful effects, a higher inflation target in the next few years would help erode the onerousness of debt overhanging U.S. households. For another, while some have argued that the recent extended period of economic slack has damaged the economy’s productive potential, even if this was true the best response to this would not be to accept some disappointing “new normal.”

The best response would instead be to remedy this damage with an extended period of rapid economic growth. The boom of the late 1990s that saw tight labor markets and growing productivity reinforce each other in a virtuous cycle without leading to accelerating inflation should have taught policymakers to tighten only in the face of actual, not anticipated, inflation accelerations.

Yellen’s continued insistence on not sticking dogmatically to the 6.5% threshold is welcome. We are still far from full employment, and tightening before we get there would be bad policy. Best of all would be to have Yellen’s view even influence fiscal policymakers to reverse the austerity of recent years, but I’m not holding my breath on that one.